Microfinance: Then and Now

Posted in Finance Articles, Total Reads: 2553
, Published on 18 November 2013

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Microfinance is a provision for providing credit access to low income group especially women in semi urban and rural areas. The microfinance sector has expanded rapidly in India by providing access to credit to those who do not have access to the gamut of financial services in the country. According to World Bank estimates, around 50 crore people have directly or indirectly benefited from microfinance related operations globally. Infact, Indian microfinance industry (MFI) is pegged as largest in the world with 2.6 crore clients. Also, the private sector MFIs have provided gainful employment by employing more than 80,000 rural youth throughout the country.

image reference:Stuart Miles, http://freedigitalphotos.net

The origin of microfinance in India can be traced back to early 1970s when the Self Employed Women’s Association of Gujarat formed Shri Mahila SEWA Sahakari Bank (an Urban Cooperative Bank) with the core objective of providing banking and financial services to poor women who were employed in the unorganised sector in Ahmedabad. The sector evolved further in the 1980s around the concept of Self Help Groups (informal bodies which provides their clients savings and credit services). MFIs started using Self Help Groups’ peer pressure and group savings as a substitute to collateral.

From its humble beginnings, the sector has grown significantly and has become the ‘poster boy’ of financial inclusion in the country. The average year-on-year increase in the period of 2004-2009 was around 107%. The high point for the industry came when SKS Microfinance went public in 2010 and the issue was 13 times oversubscribed.

In the meanwhile, the borrowers started taking new loans to repay old loans which ultimately led to a downward spiral in the form of over-indebtedness. They also started resorting to extreme measures for making repayments like reducing their consumption of food. Thus, this over-indebtedness led to increase in financial and social vulnerability of the borrowers and sometimes severe consequences like suicides. These consequences paved path for the government`s interference. And, in 2010, Andhra Pradesh government took a tough stance on the practices of the industry thereby, hindering the sector’s growth story. It passed Andhra Pradesh Microfinance Institutions (Regulation of Money Lending) Act, 2010 which made it mandatory to take government’s approval before giving another loan to the same borrower. The recovery period was also extended and a restrictive ordinance was put in place which barred lenders from following coercive debt collection practices. As a result of these measures, the default rate went up to as high as 95% in Andhra Pradesh and sector`s growth plummeted to negative 14%.

The situation became so grim that the MFI’s in Andhra Pradesh which disbursed Rs 5,000 crore to borrowers in the first half of 2011 could only disburse Rs. 8.5 crore in the second half of 2011. Thus, the entire microfinance industry was brutally shaken up and MFI’s all over India (not just in Andhra Pradesh) had trouble accessing financial avenues.

During this period, RBI played a significant role in rejuvenating the lost confidence in the industry. It formed the Malegam Committee whose recommendations led to the introduction of strict federal regulations on microfinance operations and a licensing system in February 2011.These guidelines were ultimately aimed at drawing a line between profits and micro-lenders. Most MFI’s are now charging around 25% interest rate.

The gross loan portfolio (GLP) has risen by 23% from Rs.17, 264 crore in 2011-12 to Rs.21, 245 crore in 2012-13 indicating that the industry is recovering from 2010 crisis. Growth was largely driven by non Andhra Pradesh MFIs which grew by 39%. States of Punjab (56.4%), Kerala (35.6%) and Uttar Pradesh (34.8%) recorded the highest growth in terms of GLP. In absolute terms, Andhra Pradesh (19%) remained at top because of the presence of significant non-performing assets in balance sheet of MFI’s. It was followed by West Bengal (14%) and Tamil Nadu (13%).

One important consideration is that high cost of undertaking small transactions in rural coupled with a cap on interest rates may drive away MFIs from opening branches in remote villages. So far, MFIs have not been able to achieve their target of social performance management and client protection. Majority of them focus more on delivering financial services which serve the poor with high commitment to operating profitability. Many MFIs have been accused of different accounting practices and hiding effective interest rates from the poor borrowers.

Thus, all these regulatory changes have ultimately added to confusion and chaos in the microfinance sector. Banks have started to withdraw funding from the MFIs and the industry has continued to shrink. So, the sector is facing multiple challenges of having less financial reserves, reduced profit and increased international scrutiny.

The Road Ahead

The industry has evolved after the Andhra Pradesh Crisis. Microfinance Institutions (Development and Regulation) Bill, 2012 which deals with regulatory issues and elaborates the role microfinance institutions is awaiting parliamentary approval to become a law. The bill would ensure orderly growth in the rural and urban areas.

However, to achieve the primary aim of MFIs: social performance management and client protection, MFIs should also indulge in responsible financing. Responsible financing focuses on a client-centred approach towards adapting financial products and services. It is a never-ending process of keeping clients at the centre. Thus, MFI service providers should design appropriate products, rules keeping in mind the clients need and repayment capability in order to achieve client protection. Information about effective interest rates, dormancy fees etc. should be made available to borrowers. They should track borrower’s usage of the microcredit and help them in poverty alleviation through proper allocation of income. They should also stress at providing financial education along with social services.

To promote responsible financing, an NGO plus MFI model should also be promoted. An NGO engaged in the MFI activities will primarily focus on the development aspect of the poor, not profit generation. It will also help the MFIs to improve the structural efficiency in the loan recovery process.

Another domain in which MFI’s can venture into is channelising of microinsurance products through its distribution channel. A microinsurance plan provides protection to lower income group individuals having little savings and is specifically tailored for lower valued assets and compensation for illness, injury or death. Since, the coverage value is lower than a normal insurance plan (benefits paid out is less than Rs. 50,000), smaller premiums are paid. MFIs typically receive a commission of 20% to 40% on the first year premium of the policies. A recent study by UNDP has estimated the potential market size for microinsurance in India to be between Rs 62,000 million and Rs 84,000 million.

Two major type of microinsurance products are: Insurance against medical and hospitalisation expenses, and insurance against loss of crop failure. These risks are increasing in the rural areas; hence the MFIs can leverage their established distribution channel and relationship with natives to sell these products in order to improve their overall profitability. This would help them to mitigate the losses faced by defaults on their loans. Highly profitable MFIs can also offer lower interest rates as a result of improved overall margins.

Although the microfinance sector has lots of potential but still there are many roadblocks which needs to be taken care off. They need to revamp their operational processes and reengineer more cost efficient systems to reduce the likelihood of client abuse and improve social performance. Smaller MFI’s can look for consolidations and mergers in order to attain economies of scale. They need to be more transparent about their interest charges and terms and conditions and convey them to borrowers in easy to understand form. Thus, in a nutshell, microfinance is a potent step towards achieving the dreams of an equitable society. The sector is currently at a critical point and a deep understanding about its dynamics can assist policymakers in formulating and implementing future plans for financial inclusion.

The article has been authored by Mehak Kanotra and Mohit Ahuja, TAPMI Manipal.